India’s business cycle is getting similar to that of advanced economies

Chetan Ghate, Radhika Pandey, and Ila Patnaik  write this nice paper on the topic (HT Ajay Shah Blog). The paper has some amazing findings as suggested by the title itself.

The paper begins with a superb discussion of business cycles in emerging and developed. I am yet to see a paper write so clearly about such complex topic in plain english.

Basic idea is that business cycles of emerging/developing economies are more volatile. This leads to more volatile output, consumption, investment etc. As an economy develops, one should see lower volatility in all these dimensions. The paper finds similar thing happening for India.

A large literature documents business cycle stylised facts both in advanced industrial economies (Kydland and Prescott, 1990; Backus and Kehoe, 1992; Stock andWatson, 1999; King and Rebelo, 1999) as well as developing and emerging market economies (Agenor et al. , 2000; Rand and Tarp, 2002; Male, 2010). Agenor et al. (2000) present a comparison of the business cycle  properties of developed and developing economies based on a quarterly dataset from rst quarter of 1978 to the fourth quarter of 1995. The Index of industrial production (IIP) is taken as a proxy for aggregate business activity. Cyclical components of variables are derived using both the Hodrick-Prescott and Baxter-King filters.

A main nding of the paper is that developing economies are characterized by higher output volatility compared to developed economies. Similarly, Rand and Tarp (2002) report business cycle stylised facts for 15 developing economies based on an annual dataset from 1970-1997. gdp is taken as a proxy for aggregate business activity. These authors find that output volatility in developing economies is 15-20% higher than that of developed countries. They also find that consumption is more volatile than output for developing economies (with South Africa and India as exceptions). Volatility in investment is found to be similar to developed economies. However, they do not find any consistent evidence of counter-cyclical government expenditure in their sample of developing economies.

The paper looks at how business cycles in India has behaved from 1950-2009. The divide the period as pre-reform (1991) and post-reform and find post 1991, parameters have started resembling that of developed economies.

Because India is typically treated as one of many countries within a larger sample (see (Agenor et al., 2000; Rand and Tarp, 2002; Male, 2010)), such studies do not show the changing nature of the business cycle of any particular country over time. Our main contribution is to provide evidence on the changing stylised facts of the Indian economy from 1950 – 2009. During this time, India transitioned from a closed and protected economy characterised by controls on capacity creation and high import  duties, to an economy well-integrated with the world, with the policy environment changing significantly in 1991. In terms of business cycle fluctuations, the economy moved away from monsoon cycles (Patnaik and Sharma, 2002) to business cycles in the conventional sense. The empirical literature on stylised facts relies on long time series of quarterly data. However, quarterly gdp data in India is available only from 1999. This limits us to 11 years of quarterly data for our key variables. Hence, since we are interested in the changing pattern of the Indian business cycle, we conduct our analysis with annual data and then use the quarterly data to check the robustness of our results.

In particular, we are interested in the properties of Indian business cycle over two periods: 1950-1991 for the pre-liberalisation period and 1992-2009 for the post-liberalisation period.  gdp , private consumption, total gross xed capital formation, consumer prices, exports, imports, government expenditure and nominal exchange rate are the key variables analysed.

Findings are amazing. They see both similarities and differences with developed economies’ cycles:

In terms of similarities, we find that

  • output (Real gdp) has become less volatile in the post-liberalisation period;
  • investment has become significantly pro-cyclical in the post- liberalisation period;
  • the correlation of imports with gdp has also increased;
  • net exports have become counter-cyclical;
  • the volatility in prices and government expenditure has decreased in the post liberalisation period;
  • and the absolute volatility in nominal exchange rate has declined.
  • Further, our results using quarterly data are consistent with the findings of the annual data analysis for the post 1991 period.
  • This suggests that in many key respects, the Indian business cycle shows a growing resemblance with those of the developed economies.

In terms of differences, the Indian business cycle features also resemble features of developing economies.

  • While output  volatility has fallen, it still remains high.
  • In addition, consumption is more volatile than output.
  • Further, government expenditure is not strongly counter-cyclical with respect to output, as in advanced economies.

I was really surprised over this counter-cyclical government expenditure finding. It runs deficits/higher expenditure both in good and bad times. Other factors one does see but the fact that it is closer to developed economies is nice to see.

There are some superb tables and graphs to explain this decline in macro volatility in India. Very neatly explained.

The paper has some interesting implications as well. Volatilty is a both source and reflection of underdevelopment, and is a main sign of weakness in developing countries. People are never confident over growth outcomes as the variance is very high. This leads to uncertainity over investment. Then you have large external shocks, volatile macroeconomic policies, microeconomic rigidities, and weak institutions. A less volatile business cycle makes people more confident over future outcomes and helps plan better. It enables people to take more risks as well.

Hence, findings augurs well for Indian economy

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